On October 15, 2009, the Program on America and the Global Economy hosted a book discussion regarding the vulnerability and fragility of processes of globalization, both historically and currently. Harold James, professor of History and International Affairs at Princeton University presented his book The Great Creation and Destruction of Value: The Globalization Cycle. Kent Hughes, Director of the Program on America and the Global Economy served as moderator.

In the midst of a financial crisis, people look to the past for guidance, James asserted. During the present crisis, economists and academics are searching for guidance from the 1920s and the Great Depression. In fact, the Chairman of the Federal Reserve, Ben Bernanke, and the Chair of the Council of Economic Advisers, Christina Romer, are both economic historians who have made "significant contributions to the story of the Depression."

In his analysis, much of the discussion on the causes of the Great Depression focuses on the wrong aspects. Conventional wisdom states that to understand the Depression, one has to look to the stock market crash of October 1929. This is complicated because finding the causes of that market crash is like the "search for the Holy Grail...you never really arrive there." James argued that although the crash led to some reduction in wealth, it didn't have a significant effect on worsening the economy. In the time since the crash of 1929, economists have developed two lessons, he said. The first is a countercyclical policy to produce demand when demand is not there—a Keynesian approach. The second lesson comes from the insight put forward by Milton Friedman and Anna Schwartz in their 1963 volume, A Monetary History of the United States: 1867-1960 that pointed to a monetary contraction during the period from 1930 to 1933 as the principal cause of the Great Depression. During every subsequent market crash, central banks have injected liquidity in the market. Indeed, during the present crisis, central banks have infused unprecedented amounts of liquidity into the market. Current policy has followed both lessons. According to James, fiscal stimulus is working in the U.S., and it's working even better in China. At the same time, the Federal Reserve has been aggressive in injecting liquidity into the financial system.

James then described what he believed led to the Great Depression, an event of "unparalleled voracity and destructive power." He said that it started from a "series of contagious financial crises" that spread from Central Europe to the U.K. in 1931. Then, after September 1931, when the pound was taken off the Gold standard, the crisis spread to the United States. Europe's banks in 1931 were as James put it, "too big to fail." Contrary to modern day understanding of the Great Depression, the root of economic collapse can be attributed to the big insolvent European banks. The collapse of the financial system in the 1930s and again in 2007-2008 destroyed institutions, net-works, and the trust among institutions and investors. By itself, macroeconomic policy will not be sufficient to restore the financial system.

The conversation moved onto the question of de-globalization. In the 1930s, de-globalization took the form of competitive devaluations of currencies and a turn to trade barriers as countries sought to stimulate their domestic economies. In the most recent crisis, there has relatively little resort to trade protectionism. Instead, nationalism, particularly in Europe, took the form urging rescued companies to reduce their foreign exposure, a kind of lend national policy. Such a "financial nationalism" is evident in the UK, he said. Tax payers are adverse to rescued companies pursuing international activities. For instance, one of the critiques of Citigroup's poor financial situation was that it was too active in too many countries.

James also noted that smaller, open economies would have more difficult turning to a Keynesian policy of fiscal stimulus. For instance, a small country like Luxembourg may not be able to adopt a Keynesian like stimulus because much of the effect would be felt outside their borders. Even company specific spending might have limits where the local company actually did much of its work outside the borders of the nation state. The more, open, more globalized world is creating, what James calls, a "new economic geography of the world," where attention has shifted to big, powerful states, such as China, India, and the U.S. Smaller countries that benefited from globalization in the 1990s are now more vulnerable. James said that this has lead to a return of big governments and power politics.

James moved on to what the guidelines for policy will be in the post-crisis world. The Bretton-Woods dollar standard (with the dollar linked to a set price of gold) collapsed in 1971 to be replaced by a regime of floating exchange rates. In terms of domestic monetary policy, there was an attempt to apply Milton Friedman's prescription of a steady growth in the supply of money. There was a debate over which measure of money to use but, eventually, the policy was abandoned as the velocity of money (how often money turns over) proved to be variable. In the 1990s monetary targeting was largely replaced, and in countries like New Zealand, United Kingdom and Sweden inflation targeting became the norm. At the time, this was thought to be a very stable framework for making monetary policy. But, as is evident from the crisis today, the inflation targeting approach doesn't give an adequate guide on how to deal with asset price bubbles.

In more recent times, the conventional view has been that asset booms were not that concerning. Former Chairman of the Federal Reserve, Alan Greenspan, frequently argued that raising interest rates to control asset booms would be very costly in terms of foregone growth and unemployment. Instead, he felt it was better to focus Federal Reserve policy on responding to the fallout when the bubble eventually burst. In light of the recent crisis, central bankers are rethinking their approach to asset bubble.

After his presentation, James took a question from a member of the audience regarding the trade imbalances with China. He addressed the question from the perspective of two stories about Chinese surpluses. The first is that the Chinese government keeps a depreciated currency because it is concerned about internal political stability. In a sense this is grounded in a "classically mercantilist perspective." The other story behind Chinese surpluses is that it is a reaction to financial crises of the past. After the economic shock of 1997-8, Asian governments learned to accumulate big reserves to avoid vulnerability.

Drafted by Matthew Clarkson, PAGE
Kent Hughes, Director, PAGE